It’s a good thing that most of us don’t worry about financing our children’s college education before we decide to have them. If we did think about those future costs, chances are our logical selves would counsel very strongly to stay out of the child acquisition mode. Just think of all the fun, heartache and sheer joy we would miss out on if Mr. Logical won.

Still, the cost of providing a college education for our children is one of those things that will weigh heavily on our minds right up to the time they graduate from college. And it may very well weigh heavily on our pocketbook for years after their graduation. Luckily, our good old Uncle Sam has provided a little assistance in the form of a tax advantaged, tuition prepayment/investment vehicle called the 529 Plan.

The 529 Plan

Forty seven states so far have implemented some form of the 529 Plan, which was first offered by New Hampshire in 1997. The 529 Plan allows you set up a tax-deferred savings account for your children's college expenses regardless of income level. It allows states to offer tax breaks and investment vehicles customized for college savings. The offerings vary from state to state but all offer tax-sheltered funds to parents, grandparents or anyone else who might feel compelled to donate to your children's higher education. When the money is withdrawn for qualified purposes, the gains are federal tax-free from 2002-2010. Unless Congress changes the law, after 2010 the income portion of the withdrawal will be taxed at the child's low rate. All amounts initially contributed may be withdrawn tax-free.

Differences by state

States offer added incentives such as a state tax deduction on contributions to the plan or even a state-tax credit. Missouri for example, offers state residents an annual $8000 deduction on contributions. Each state's plan has different investment options and each state offers its own array of incentives in an effort to keep residents' dollars at home. Some states offer only prepaid tuition plans. While the tax incentives of these plans are technically the same, they require that the education be in the same state where you have the contract. Some states offer only savings plans, which are more akin to investments which can be moved if you should so decide. When "shopping states" you need to consider the impact of the tax incentives and investment choices offered by the states in which you have an interest. Be careful, once you choose a state, you cannot change for a year and your money is in the hands of that state.

The 2001 tax law changes add a new wrinkle in the college savings landscape. Now private institutions of higher learning are allowed to establish their own 529 plans. You can start making qualified withdrawals from these plans in 2003.

How it works

If you choose to use the 520 Plan as a savings vehicle for your child, you’ll enter into an agreement with the state or institution of higher education you choose. At that time, you’ll make a decision as to which investment vehicle you’ll use and how much you wish to contribute. Thereafter, depending on plan design, you may make regular deposits, a one-time deposit, or a combination thereof. From there, the professional money manager of the 529 Plan will manage your investment and you’ll essentially be out of the picture.

Once each year, you’ll have the option to change investment direction and/or move the money to another entity’s’ plan. Until the new law was enacted, this was not permissible unless you were transferring funds from one beneficiary to another. This is an important new feature that can help you manage the use of the funds.

Downside of the 529 Plan

It’s hard to say anything bad about the 529 Plan since there are so many advantages but you need to know one or two things. To a large extent, you’re losing control of your money. For some, this could be a good thing, but generally speaking you need to do your homework and make sure the program you select meets your investment needs.

A second downside to consider is that the mere existence of the 529 Plan for your child can have a negative effect on eligibility for financial aid. This is, however, the price you pay for planning. The bottom line is, regardless of where the assets are held (in your account at Make You Rich Financial Services or with a 529 plan), those assets will have a negative effect on eligibility for the various financial aid programs.

Upside of the 529 plan

The biggest advantage to parents is that they’re allowed to defer state and federal taxes. Some states allow $100,000 or more per child. Grandparents can join in and so can anyone else under special regulations. The only rule is that the money be spent on college expenses. If the child does not use all the money for college, you can roll the account to a different child. If you have no other children going on to college, you can withdraw the assets and you only pay taxes on the growth and income at your rate.

A second advantage is that the money remains under your control, unlike accounts set up under the Uniform Gifts to Minors Act (UGTMA). The entire balance of UGTMA accounts must revert to the beneficiary when they reach the age of majority (generally 18). Can you imagine giving an 18-year-old $250,000 (or $25,000 for that matter) to spend on college? Granted, many young people are responsible, but there are many who are not and that uncertainty could undo all of your hard work and planning if your child shows up after the first semester with a new Lamborghini.

Who can participate?

Anyone can and it doesn’t matter which state you live in. You’ll still get the benefit of federal tax deferral and the low rate (your child's) when you withdraw the money at college time (if it’s outside of the 2002-2010 corridor and full tax exemption isn’t restored). You can use the money for more than just the tuition. You can pay for books, room and board, or anything directly related to college or graduate school.

The 529 Plan is uniformly accepted as one of the best ways to save for your children's college. There are other plans, such as the Education IRA, but their contribution limits are quite low compared to college costs.. The 529 plan will continue to change the way millions save for college and this will no doubt impact how you spend your golden years.

If you have children, now is the time to begin saving for their college education. Please, take this opportunity to come by and visit so we can review your plans and make sure they meet your needs.

These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.